By Martin Wolk Executive business editor
updated 9/24/2004 6:41:51 PM ET 2004-09-24T22:41:51

The Federal Reserve raised short-term interest rates for the third time in three months Tuesday, saying the economy has "regained some traction" after a slowdown earlier this year. The quarter-point rate hike, which increases borrowing costs for consumers and businesses,  signals that Fed Chairman Alan Greenspan and his colleagues are comfortable that the economy has passed through the so-called “soft patch” of slow growth, even if the pace of expansion remains modest.

The decision to raise rates, which had been widely expected, was made at the final scheduled meeting of policy-makers before the Nov. 2 election. The Fed offered only a hint as to what it might do next, suggesting to some analysts the possibility of another rate hike in the near future. In a statement, the central bank said policy "remains accommodative" and that policy-makers believe they can continue raising rates at a "measured" pace.

But echoing Greenspan's Sept. 8 congressional testimony, the Fed noted that "inflation and inflation expectations have eased in recent months," which could give central bankers the flexibility to move to the sidelines soon.

Video: Deconstructing the Fed By acting Tuesday the Fed brought the benchmark federal funds rate to 1.75 percent, compared with a 46-year low of 1 percent before the current tightening cycle began June 30. Leading banks followed suit by raising the prime rate to 4.75 percent from 4.5 percent.

The federal funds rate is what banks charge each other for overnight loans, while the prime is the best rate generally available to consumers and businesses with good credit.

By describing current monetary policy as “accommodative,” policy-makers left plenty of room for additional rate hikes without risking a substantial economic slowdown. But last week’s report that consumer prices barely budged for a third month in a row gives the central bank the flexibility to move to the sidelines without a great fear of inflation, said David Rosenberg, chief North American economist at Merrill Lynch.

He pointed out that the Fed began raising rates this year after a spike in inflation accompanied by a surge in hiring.

“Here we are today, and one of the big surprises is that the inflation numbers have come back to Earth,” he said. “It’s the first time in 50 years the Fed has embarked on a tightening cycle in a period of such pure price stability.”

He said he still expects the Fed to raise rates at its next meeting Nov. 10, but said the decision is not yet a "slam dunk."

While most analysts still expect a rate hike Nov. 10, some disagree as economists debate just when and whether the Fed will pause in its tightening cycle.

Wachovia economist Mark Vitner said he expects the Fed to keep rates unchanged in November, now that the overnight rate is above the core rate of inflation.

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"The Fed is probably feeling pretty good about things," he said. "I think they've moved far enough for now. ... With oil prices rising as much as they are the Fed has to tread lightly. It wouldn’t take much to push the ecnomy over the edge."

On the other hand Bill Cheney, chief economist for MFC Global Investment Management, said he expects the Fed to raise rates steadily, boosting the federal funds rate to 4 percent by late 2005.

"Speculation has been growing that the Fed might skip a hike at this meeting or perhaps in December or January, and while it's possible, I think it's more likely that they'll just keep going," he said in a note. "The economy is neither roaring nor stalling. It's clearly out of the soft patch and moving along at a decent pace, and that's all the Fed needs right now."

Bond markets rallied after the Fed's afternoon statement, sending long-term interest rates lower on the expectation for continued low inflation. Stock prices rose modestly.

Ethan Harris, chief U.S. economist for Lehman Bros., said that by fully telegraphing its action Tuesday and issuing a balanced statement the Fed has done a "remarkable" job of staying out of the political line of fire despite raising rates in the middle of a hotly contested election campaign.

"They have done a great job of keeping to a nicer steady course," Harris said. "If they are going to move to the sidelines they have to change their tune a bit."

Harris said he expects the Fed to raise rates one more time in November and then go on hold. He and other analysts pointed out that the Fed is reluctant to raise rates in December due to special year-end issues including the difficulty of adjusting for seasonal factors.

"We don't think they are trying to signal anything with this directive," he said. "It's too early and would muddle the message they are trying to send."

Tony Crescenzi, chief bond market analyst for Miller Tabak & Co., said that by hiking the overnight rate by three-quarters of a point, the Fed has essentially taken away two rate cuts,  one from 2002 and one from 2003, that were described as “insurance” for an economy struggling to rebound from the recession of 2001.

The extra monetary stimulus, boosted by last year’s tax cuts, fueled strong growth of up to 7.4 percent late last year. But growth has slowed substantially since then, with the gross domestic product rising at a modest 2.8 percent pace in the second quarter of this year.

Full text of Fed statement
The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 1-3/4 percent.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. After moderating earlier this year partly in response to the substantial rise in energy prices, output growth appears to have regained some traction, and labor market conditions have improved modestly. Despite the rise in energy prices, inflation and inflation expectations have eased in recent months.

The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Thomas M. Hoenig; Donald L. Kohn; Cathy E. Minehan; Mark W. Olson; Sandra Pianalto; and William Poole.

In a related action, the Board of Governors unanimously approved a 25 basis point increase in the discount rate to 2-3/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

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